INCOME AND BENEFITS POLICY CENTER RESEARCH REPORT Reforming the Social Security WEP Exposes Weaknesses in State and Local Pensions Chantel Boyens Erald Kolasi Jack Smalligan March 2019 ABOUT THE URBAN INST ITUTE The nonprofit Urban Institute is a leading research organization dedicated to developing evidence-based insights that improve people’s lives and strengthen communities. For 50 years, Urban has been the trusted source for rigorous analysis of complex social and economic issues; strategic advice to policymakers, philanthropists, and practitioners; and new, promising ideas that expand opportunities for all. Our work inspires effective decisions that advance fairness and enhance the well-being of people and places. Copyright © March 2019. Urban Institute. Permission is granted for reproduction of this file, with attribution to the Urban Institute. Cover image by Tim Meko. Contents Acknowledgments iv Reforming the Social Security WEP Exposes Weaknesses in State and Local Pensions 1 Social Security Coverage 2 Treatment of Noncovered Earnings in Social Security 3 The Equal Treatment of Public Servants Act of 2018 5 Estimated Impact on Beneficiaries 7 Noncovered State and Local Government Workers and Their Pensions 8 Analysis 11 Policy Options 15 Request Additional Analysis 16 Update Regulations Governing Noncovered Pensions 16 Modify PSF and Improve Administration 16 Implement Universal Coverage 17 Conclusion 17 Appendix A. Brief Primer on Actuarial Methodology 20 Appendix B. PSF and Pattern of Earnings 22 Notes 24 References 25 About the Authors 26 Statement of Independence 27 Acknowledgments This report was funded by the Laura and John Arnold Foundation. We are grateful to them and to all our funders, who make it possible for Urban to advance its mission. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders. Funders do not determine research findings or the insights and recommendations of Urban experts. Further information on the Urban Institute’s funding principles is available at urban.org/fundingprinciples. The authors appreciate the helpful suggestions of Chad Aldeman, Matt Chingos, Stephen Goss, Karen Glenn, Richard Johnson, Laura Quinby and Jacqueline Walsh. Thanks also to Michael Marazzi and Archana Pyati, Urban Institute colleagues who provided editorial and dissemination support for this report. IV ACKNOWLEDGMENTS Reforming the Social Security WEP Exposes Weaknesses in State and Local Pensions Approximately 25 percent of state and local government workers, about 5 million people, are currently working in jobs not covered by Social Security.1 Instead, these workers participate in government pension plans that are required to provide benefits at least equivalent to those provided by Social Security. Many of these workers will also hold jobs in Social Security–covered employment over the course of their careers and will become eligible for benefits under both systems. Under current law, retirees receiving pension benefits from a noncovered job may have their Social Security benefits reduced by the Windfall Elimination Provision (WEP). The WEP is intended to ensure that the Social Security benefit formula does not replace a higher share of earnings for these workers than for those who only worked in jobs covered by Social Security. Unfortunately, the WEP does not treat all workers fairly and is poorly understood by beneficiaries, catching many by surprise once they reach retirement and failing to identify other beneficiaries who should have their benefits reduced. These concerns have generated bipartisan support to reform the WEP and some groups have called for its full repeal. The Equal Treatment of Public Servants Act,2 last proposed in 2018 by Representative Kevin Brady, aims to fix the WEP by replacing it with a more equitable formula for reducing Social Security benefits that uses newly available data on workers’ covered and noncovered earnings. It establishes a new formula, known as the Public Servant Fairness Formula (PSF), that would make important and needed improvements to the WEP. The proposed formula would increase benefits for most workers who would normally be affected by the WEP. But it would also impose new benefit reductions on millions more beneficiaries who never receive a public pension or only a very small one, many of who would not have their benefits reduced by the WEP. This brief explores how Social Security benefits would be affected for workers facing new reductions under the PSF. Those who would be most affected by new reductions are beneficiaries who never receive a benefit in retirement from their government pension plan, either because they do not vest for benefits or because they withdraw their contributions when they separate from their job. These workers have relatively shorter careers in state or local government and, consequently, also receive less in public pension benefits because those plans typically structure benefits to generously reward long careers. The retirement security of these workers, many of whom are teachers, may also be undermined because their public pension plans fail to provide benefits truly equivalent to those offered by Social Security (Aldeman 2016; Quinby, Aubry, and Munnell 2018). For some of these workers, the PSF would reduce Social Security benefits by more than the amount of their noncovered pension. It would also reduce benefits most for those who are already getting the least out of their noncovered pensions. Policymakers considering legislation to improve the WEP could request further analysis of how future beneficiaries would be affected by the proposed bill. They could also consider shoring up the regulations governing noncovered pension plans, building in protections to the PSF for short-tenure workers, identifying new methods to administer the WEP, and developing a pathway to achieve universal Social Security coverage to improve retirement security for all workers. Social Security Coverage Social Security was designed to provide universal social insurance to all American workers. When the Social Security Act was passed in 1935, however, it exempted all state and local government employees from coverage because of constitutional concerns about the right of the federal government to impose taxes on the states (Solomon 1986). Further, most state and local government workers were already covered by comparable pension plans. Over time, the constitutional concern eased, and Congress passed new laws that expanded coverage to most government workers, including all federal employees. In 1990, Congress passed the Omnibus Budget Reconciliation Act and established the system for coverage we have now. That act required states and localities to adopt Social Security for their workers unless they provided an alternative pension benefit equivalent to Social Security. Moreover, once a government employer adopted Social Security coverage, it could not drop it. State and local governments that continued to offer pension plans in lieu of Social Security had to ensure that the benefits provided through their plans were at least equivalent to those provided by Social Security. Today, Social Security covers approximately 94 percent of all US workers.3 The remaining 6 percent are primarily state and local government employees. Although most state and local government employees are covered by Social Security, about a quarter of them, almost 5 million, are not (Quinby, Aubry, and Munnell 2018), including many teachers. Although some of these government employees will work their entire career in jobs not covered by Social Security, many will work in a mix of covered and noncovered employment over the course of their careers. 2 REFORMING THE SOCIAL SECURITY WEP EXPOSE S WEAKNESSES IN PENSIONS Treatment of Noncovered Earnings in Social Security Workers who split their careers between covered and noncovered employment pose a problem for Social Security because of how the benefit formula is designed and the way that earnings are tracked by the Social Security Administration (SSA). QUARTERS OF COVERAGE Social Security benefits are determined based on a person’s earnings while in Social Security–covered employment. Covered workers and their employers pay payroll taxes on their earnings up to the taxable maximum, and these taxes are deposited into the Social Security trust funds and used to finance benefits. Workers become insured for Social Security retirement benefits when they earn 40 quarters of coverage, which is equal to about 10 years of covered work. In 2019, a worker must earn $1,360 to gain a quarter of coverage. Eligibility for disability insurance benefits requires fewer years of coverage for younger workers, but some of those years must be recent (SSA 2019). For any years in which a worker was not employed, had earnings below the threshold, or worked in employment not covered by Social Security, SSA records their earnings as zero. For people who were actually employed in noncovered work and earning noncovered pension benefits, those years of zero recorded earnings can distort benefits calculated under Social Security’s progressive benefit formula, described in the next section. SOCIAL SECURITY BENEFIT FORMULA Social Security benefits are calculated by first indexing a worker’s earnings based on annual changes in average wages nationwide. SSA then determines a person’s highest 35 years of covered earnings and averages them to yield the his or her average indexed monthly earnings, or AIME. If a worker has less than 35 years of covered earnings, zeros are included in the calculation. The AIME is then used to calculate the primary insurance amount (PIA), which represents the monthly benefit amount that the beneficiary receives before any adjustments are made. The PIA is calculated by segmenting the AIME between “bend points.” A separate benefit rate is applied to the earnings in each bracket. The bend points are indexed annually for workers becoming newly eligible for benefits by the average wage index. For workers becoming newly eligible in 2018, the formula replaced 90 percent of earnings up to $895, 32 percent of earnings between $895 and $5,397, and 15 percent of earnings over $5,397.